Friday, July 03, 2009

Balance and Reversion

Taoism talks about being in tune with the Universe and consequences of allowing a strong force to overwhelm others. Yes we are talking about the Yin and the Yang. Both forces should balance each other to achieve Balance. A stronger Yin over Yang or vice versa leads to unrest, discomfort and ultimately it calls for a reversion to the mean.

In Graham-speak, this becomes Bond versus Stock. Back in his days where there were only 2 asset classes: Bonds and Stocks, his strategy was to always maintain a portfolio with at least 25% in one asset class and a maximum of 75% in the other. And this is when one asset class in grossly overvalued versus the other. In most cases, it should be a 50:50 split between bonds and stocks.

So as with Taoism, the ideal situation is always an equal split between the bonds and stocks. Both asset classes will be in balance. Bonds give income, stocks give capital appreciation. Bonds counter deflation, stocks counter inflation. Bonds, downside protection, stocks provide upside. Totally in sync with the Universe!

However there are times when a stronger force overwhelms the other. With investment, well usually a stock bubble brings valuation so out of whack that it makes sense to disrupt the balance. In this case, overweight bonds and underweight equity. Ultimately, the Universe must return to its status quo, ie stocks will correct to its appropriate valuations and the investor benefits.

Value investing focuses a lot on the process up till buying the stock. But very little is said about selling. Buffett, the Oracle of Omaha, is famous for saying you never sell a good stock except when you want the money to buy a better one. Graham never specifically said anything about selling as well.

But I guess, by reading between the lines and drawing lessons from Taoism, we should sell when things are out of balance. In the case of stocks, when it’s grossly overvalued. The sad mistake we all make is to rationalize the overvalue-ness to justify why we still hold on to the stock. Like the company has this new product that will be a hit, or the company is going to do M&A, or the company is going to increase dividends etc.

So the next time we want to hold on to a stock that had gotten too expensive, think about the balance of the Universe and why reversion will always occur and it’s time to allow that to happen. Sell the damn stock.